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Monday, 9 October 2017

A well-deserved Nobel prize for a man that helped establish a new field of behavioral economics, disrupted the academic milieu in the rigid field of finance, and successfully started implementing his ideas as actual policies in a number of countries (most famously through the Nudge Unit in the UK - officially Behavioural Insights Team - set up under Cameron's administration, and the White House Social and Behavioral Science Team, set up under Obama's administration). It wouldn't be exaggerating to say that Thaler's scientific contributions were among the most applicable of all Nobel prize winning contributions in economics thus far (even more than Roth's kidney markets, Fama's EHM and Shiller's Irrational Exhuberance, or Deaton's measurements of poverty and inequality, to name just a few most recent notable laureates).

It's been 15 years since behavioral economics has been recognized for the first time by the Nobel Committee, awarding it to Daniel Kahneman (together with Vernon Smith for advances in experimental economics). After Kahneman and Tversky, psychologists who founded the field, Thaler is definitely its most notable contributor, having performed many experiments and having seen his recommendations become actual policy prescriptions designated at making the system a bit more efficient (or as he would put it, more suitable for imperfect Humans, rather than perfect Econs). And precisely because Humans are imperfect, because they lack self-control, because they suffer from asymmetric information, because they tend to rely on System 1 (quick thinking) rather than System 2 (analytical thinking), even when making important life decisions that would benefit from some deeper thinking, they should be "nudged" in the right direction that helps them make the optimal choice, rather than an inefficient (irrational) one. By exploiting our inertia and our propensity to fall victims to availability heuristics, hindsight bias, anchoring, illusions of validity, and a whole range of other biases, we should think about mechanism design and how to present choices to people.

For example, the decision to become an organ donor after an accident. Making this the default option significantly increases the amount of people who agree to become donors. Asking the people to tick a box in order to become a donor is not the same as asking them to tick a box to remove them from the potential donor list. The same thing is with savings (for retirement) decisions - having the default option a given savings rate (say 6%) which can be changed and abandoned if anyone wants is not the same as asking the people to choose their own savings plan. In the first case someone (the employer) has made the choice for you, which you are free to alter, while in the second you have to choose for yourself from scratch, which results in the fact that most people simply choose not to. For example, the opt-in scheme (where you have to tick a box to enroll) has savings participation rates around 60%, whereas the identical opt-out (where you have to tick a box to withdraw) has participation rates between 90 and 95%. A huge and important difference.

"Richard H. Thaler has incorporated psychologically realistic assumptions into analyses of economic decision-making. By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes."

Limited rationality: Thaler developed the theory of mental accounting, explaining how people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each individual decision rather than its overall effect. He also showed how aversion to losses can explain why people value the same item more highly when they own it than when they don't, a phenomenon called the endowment effect. Thaler was one of the founders of the field of behavioural finance, which studies how cognitive limitations influence financial markets.

Social preferences: Thaler's theoretical and experimental research on fairness has been influential. He showed how consumers' fairness concerns may stop firms from raising prices in periods of high demand, but not in times of rising costs. Thaler and his colleagues devised the dictator game, an experimental tool that has been used in numerous studies to measure attitudes to fairness in different groups of people around the world.

Lack of self-control: Thaler has also shed new light on the old observation that New Year's resolutions can be hard to keep. He showed how to analyse self-control problems using a planner-doer model, which is similar to the frameworks psychologists and neuroscientists now use to describe the internal tension between long-term planning and short-term doing. Succumbing to shortterm temptation is an important reason why our plans to save for old age, or make healthier lifestyle choices, often fail. In his applied work, Thaler demonstrated how nudging – a term he coined – may help people exercise better self-control when saving for a pension, as well in other contexts."

In total, Richard Thaler's contributions have built a bridge between the economic and psychological analyses of individual decision-making. His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioural economics, which has had a profound impact on many areas of economic research and policy.

Read a layman-friendly description of his work here, and a more technical description here.

I covered Thaler's work on this blog before. I wrote a review of two of his most popular books, "Nudge" (co-written with Cass Sunstein), a book about how to apply the main findings of behavioral econ to economic policies (introducing the concept of liberatrian paternalism - giving people a choice, but still nudging them in the right direction), and "Misbehaving", his autobiographical portrayal of how the field of behavioral economics came to exist. I absolutely recommend both books to any avid reader, particularly those with a keen interest in this fascinating field, and in general to anyone interested in how the bounded human rationality affects a lot of economic outcomes, both individual and collective.

I'll finish by repeating what I said about behavioral econ when I wrote those reviews:

"...the success of the field, from its infancy during the long working hours in Stanford in early 1970s, to its profound impact on policy in the current decade, is impressive, to say the least. I don't recall any scientific field developing so quickly in terms of having an immediate impact on "the real world". And particularly a field that went against the dominant assumptions of its science at the time (the Samuelson mathematical economics revolution of the 50s, the origination of the efficient market hypothesis in the 60s, and the emergence of new classical macroeconomics in the 70s and the 80s, to mention only a few obstacles). To withheld such powerful opposition means that behavioral econ really is that good. All it takes for it now is to penetrate the principles of economics textbooks (a bold endeavor), and to finally improve decision-making in macroeconomics (something that Thaler predicts/hopes to be the next step). This will be its most difficult task. Unlike health or education economics, or savings and taxation, or finance for that matter, fiscal and monetary policy are difficult to test, and, as Thaler correctly pointed out, its theories/hypotheses are difficult to falsify (in many cases since they appear too vague, plus there's not enough data to begin with). If behavioral economics does to macro what it did to finance, it will be its ultimate triumph."

Start reading behavioral econ books and papers (there's a few suggestions at the end of this text). It will be worth it.